ECON 1P92 Lecture Notes - Excess Supply, Monetary Policy, Interest Rate

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2 Feb 2013
Chapter 28: Money, Interest Rates, and Economic Activity
Financial Assets:
1. Money- currency plus checkable deposits
2. Bonds- bought and sold in bond market
Bond is a promise to make payments at dates in future.
Present value is the current value of one or more payments or receipts made in the future- the
(discounted) present value (PV) of the bond.
The present value of any asset [e.g. bond] that yields a stream of payments over time is negatively
related to the interest rate.
Present Value and Market Price
PV of an asset is the highest price someone would pay to own the future stream of payments
from the asset.
Any price lower than the present value creates excess demand for the asset- drives up the
assets price.
The equilibrium market price of an asset is the PV of the income stream that the asset produces.
The Interest Rate Market Price
Negative relationship between interest rates and asset prices
1. If interest rate falls
Present value of an asset with a given income stream will rise
2. A rise in market price of an asset with a given income stream
Is equivalent to a decrease in rate of return earned by the asset.
Downward sloping money demand curve
At any given time the money supply is constant
Equilibrium is at I* where MD=MS
MS>MD: high rates of interest
Excess supply of money- buy bonds
Capital gain
drive down cash balances
i1 decrease -> i* Pb increase
At a low rate of i
Expect i to rise
Excess demand for money
Sell bonds
Avoid capital loss
Drive up cash balances
I increase -> i* Pb decrease
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Stocks and Bonds
Income-earning assets:
Bonds (debts) generate a stream of interest payments
Stocks (equity) generate a stream of dividend payments
Demand for money:
Lump all income-earning assets as ‘bonds’
Earn interest
Earns no interest
The Demand for Money
Money balances you want to hold
Opportunity cost of holding any money balance
Is interest earned if money used to purchase bond
Three motives for holding money:
Transactions motive
Precautionary money
Speculative money
The Transactions Motive
Transactions balances
Money balances held to make payments
If GDP is larger
More transactions
Economy holds larger transactions balances
If interest rate is higher
Fewer transactions balances held
Interest rate is opportunity cost of holding money
The Precautionary Motive
Precautionary balances
Held to protect against uncertainty of the timing cash flows
If interest rate is high
Fewer precautionary balances are held
Higher opportunity cost
The Speculative Motive
Speculative balances
Held because of uncertainty of prices of financial assets
If interest rates change
Bond prices change
Rate of return uncertain
Hold money to diversify
Financial portfolio
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